Derivatives Reform on the Ropes

Derivatives Reform on the Ropes

By THE EDITORIAL BOARD

May 19, 2013

New rules to regulate derivatives, adopted last week by the Commodity Futures Trading Commission, are a victory for Wall Street and a setback for financial reform. They may also signal worse things to come.

The regulations, required under the Dodd-Frank reform law, are intended to impose transparency and competition on the notoriously opaque multitrillion-dollar market for derivatives, which is dominated by five banks: JPMorgan Chase, Goldman Sachs, Bank of America, Citigroup and Morgan Stanley.

In the run-up to the financial crisis — and since — the lack of transparency and competition has fostered recklessness and instability. But banks like opacity, because their outsized profits depend on keeping clients in the dark about what other clients pay in similar deals. Under the Dodd-Frank law, derivatives are supposed to be traded on “swap execution facilities,” which are to operate much like the exchanges that exist for equities and futures.

Even as the new rules shift much of the trading to those facilities, they will also preserve the ability of the banks to maintain their old practices.

For instance, the commission’s initial proposal called for hedge funds, asset managers and corporations to contact at least five banks when seeking prices for a derivatives contract. In a major concession to the banks, that number was lowered to two in the final rule. Sometime in 2014, it is supposed to rise to three, but that would still be inadequate. Worse, there’s always the risk that delayed rules will never go into effect.

The initial proposal also called for derivatives trading to take place on open electronic platforms. The final rules will allow much of the negotiation over derivative prices to take place over the phone, a practice that is difficult to monitor and prone to abuse.

By themselves, these new rules are not fatal to the overall reform effort. And they are the best that the commission’s reform-minded chairman, Gary Gensler, could achieve at this time because of resistance to tougher standards by the agency’s two Republican commissioners and by one of its Democratic commissioners, Mark Wetjen.

The problem now is that Mr. Gensler’s term has officially ended, and he is expected to leave the agency at the end of the year. Given Wall Street’s incessant lobbying and powerful presence in Washington, it is assumed that he will be replaced by a chairman who is friendlier to Wall Street. That bodes ill for rules that have started out weak and need to be shored up later. To lose a reformer would also reflect poorly on President Obama, but he has not yet shown interest in keeping Mr. Gensler in the government.

In addition, none of the derivatives rules that have been finalized so far will make any real difference if they are not applied internationally. Yet Mr. Gensler has met fierce resistance — from banks, some C.F.T.C. commissioners and regulators at the Securities and Exchange Commission — to his plan to extend domestic rules to foreign affiliates of American banks and to foreign banks operating in the United States. Anything less broad would make a sham of derivatives reform.